Readers know that I am not a big fan of things European, putting it mildly. Even so, it heartens me to note that the first sensible step by governments against the excesses of the financial system was taken this week by the unlikely figure of the European Union (EU) Commissioner for Competition, Neelie Kroes.
The action that got my attention, and approval, was her ruling on the case of government aid for the Dutch banking group, ING Groep NV. As the Financial Times reported this week:
The dismantling of ING is one of the toughest interventions yet by Europe’s competition authorities, which waved through state aid to financial groups during the crisis but made clear these would be subject to scrutiny if they later appeared too generous.
ING must offload its insurance business, worth an estimated 12bn euros [US$17.8 billion] – 15bn euros, and focus solely on banking to meet the commission’s demands, a decision that goes substantially further than expected. The break-up also includes a requirement that ING sell ING Direct USA, its US banking arm.
ING will be left with a balance sheet about 45 per cent smaller than before it turned to the state last year, roughly equivalent to Commerzbank, the German lender. (Financial Times, October 26.)
Stock markets did not like the news, with the equity price of ING falling 22% from the morning of Monday, October 26, to the end of Thursday, October 29, on the Amsterdam stock exchange, with the low price on Tuesday recorded at 30% below. As the Financial Times reported on Tuesday:
Shares in ING plunged 18 per cent yesterday after the group surprised the market with a larger-than-expected cash call and plans to sell off the group’s insurance and investment management operations.
In compliance with the European Union’s competition commission, the Dutch financial group said it would raise 7.5bn euros (US$11.1bn) via a rights issue to help repay Dutch state aid and fund repayment penalties for state guarantees on risky assets.
The capital raising was 2bn euros higher than analysts at Keefe, Bruyette & Woods had expected, and the brokerage said it had put ING’s price target under review. (Financial Times, October 27.)
There are multiple approaches to the ING story; one can focus on the stock market reaction, and independently also evaluate the scale and scope of the decision itself. Since I have been writing about irrational stock market investors over the past few months, it is probably appropriate to start with that point of view.
To wit, why did equity investors not like the news surrounding ING? Based on media reports, it appears that the following were the primary factors behind the “scalded cat” reaction:
1. The business restructuring plan that ING had to do was considered much more punitive than equity holders had been expecting (hoping?) for.
2. Equity capital raising by ING was pegged sufficiently higher than the market had initially expected, diluting current shareholders further.
3. Potential future growth opportunities embedded in the equity price had diminished by the actions – for example the sale of investment management may have reduced the opportunity to earn fees.
4. Left unsaid in all of the above, the idea that ING was “too big to fail” had diminished considerably from the restructuring; that is, it had effectively become more likely that the company would be “allowed” to fail in the next crisis
There is first the matter of irrational investor expectations to consider. To expect that a failing financial institution that had been rescued with taxpayer money could get away with a low fine for its near-death experience suggests very much that investors are in a different world – filled with amnesia, rather than a belief in fundamentals. The strategy is otherwise known as a “get out of jail” card, which is to suppose that the act of bailing out an institution would create too many arguments against a future penalty.
That has now been set right. The other point to consider is that the “smaller” ING is now not of systemic importance, effectively rendering the “too big to fail” argument moot. Herein lays the route to the other part of the decision, namely its wider implications for other banking groups.
Stock markets have been debating the effects of the outburst by Bank of England governor, Mervyn King (which I highlighted in my previous article The truth about banks and dogs“, Asia Times Online, October 24, 2009), when he echoed the comments made by the well-known business economist, John Kay, on the subject of narrow banking: the fashion of separating the public utility side of banking (retail deposits, check and draft facilities, commercial lending, mortgages and so on) from the more risky “casino” type activities (investment banking, proprietary trading and so on).
The notion behind narrow banking is to create a supervisory and regulatory separation between activities that are in the public good, and those that aren’t. Following from the comments of King that elicited hostile reactions, Kay wrote again on the subject this week:
It is impossible for regulators to prevent business failure, and undesirable to pursue that objective. The essential dynamic of the market economy is that good businesses succeed and bad ones do not. There is a sense in which the bankruptcy of Lehman was a triumph of capitalism, not a failure. It was badly run, it employed greedy and overpaid individuals, and the services it provided were of marginal social value at best. It took risks that did not come off and went bust. That is how the market economy works.
The problem now is how to have greater stability while extricating ourselves from the “too big to fail” commitment, and taking a realistic view of the limits of regulation. “Too big to fail” exposes taxpayers to unlimited, uncontrolled liabilities. The moral hazard problem is not just that risk-taking within institutions that are too big to fail is encouraged but that private risk-monitoring of those institutions is discouraged.
… Their activities underwritten by implicit and explicit government guarantee, it is increasingly business as usual for conglomerate banks. The politicians they lobby sound increasingly like their mouthpieces, espousing the revisionist view that the crisis was caused by bad regulation. It was not: the crisis was caused by greedy and inept bank executives who failed to control activities they did not understand. While regulators may be at fault in not having acted sufficiently vigorously, the claim that they caused the crisis is as ludicrous as the claim that crime is caused by the indolence of the police.
The governor of the Bank of England is one of the few public officials to have grasped that the primary purpose of regulation is to protect the public, both as taxpayers and users of financial services, and not to promote the interests of the financial services industry. When the next crisis hits, and it will, that frustrated public is likely to turn, not just on politicians who have been negligently lavish with public funds, or on bankers, but on the market system …
In contrast to the lively debate being witnessed in the United Kingdom (or at least in its leading financial newspaper), the United States appears to be headed in precisely the opposite – and in my opinion wrong – direction.
To wit, the general consensus between the Federal Reserve and the US Treasury appears to be that US banks should not face either punitive charges for receiving capital guarantees, nor be forced to make amends by becoming smaller in size. The Market Watch section of the Wall Street Journal reported last week:
Federal Reserve Board governor Daniel Tarullo said Wednesday that he opposes the “provocative idea” of getting banks out of the business of trading risky securities so they can focus on lending.
In a speech to a business group, Tarullo said he doubted any such ban would end the problem of too-big-to-fail institutions, laying out a pair of objections to the idea of legislation intended to split banks up by their lines of business.
For one thing, Tarullo said, splitting them up wouldn’t end too-big-to-fail concerns because banks have shown the ability to get into trouble through risky lending alone.
Moreover, trading in higher-risk securities would have to go somewhere else if banks couldn’t engage in such activities and wherever it went, the too-big-to-fail problem would go along with it, he said. (Wall Street Journal, October 21, 2009.)
Instead, the camp to broaden regulatory powers and allow greater government supervision is the supposed panacea, according to Tarullo and his kind. The speech to the Exchequer Club made by Tarullo makes the following recommendations:
First would be creation by Congress of a special resolution procedure for systemically important financial firms … A related innovation would be a requirement that each major financial institution draw up and submit for approval to its supervisors a plan for orderly wind-down in the event of serious liquidity or solvency difficulties.
A second kind of market discipline initiative is a requirement that large financial firms have specified forms of “contingent capital.” … a regularly issued special debt instrument that would convert to equity during times of financial distress could add market discipline both through the pricing of newly issued instruments and through the interests of current shareholders in avoiding dilution.
A third improvement in market discipline could come through judicious extension of disclosure requirements for regulated financial institutions. Disclosure requirements have at times served as too easy an answer to calls for market discipline … However, an organized inquiry of actual and potential investors might identify discrete categories of information thought to have particular salience for purchase and pricing decisions.
Tarullo may have been living on a different planet than I have over the past year or so. For about the one thing that “investors” as a group have shown over the past year with respect to all classes of bank securities (senior debt, subordinated debt, hybrid capital and equity prices) has been the extremes of fear and greed.
This has been, I hasten to add, not so much a function of the inefficiency of markets per se, but rather the swings caused by the act of second-guessing government intentions at every juncture; in other words, it becomes virtually impossible to assign a fair market price to anything that is essentially a derivative product of political whim.
Given that, specifically what manner of “organized inquiry” does the good governor suggest exactly?
Rather than providing comfort, the speech filled me with dread – the notion that the US government had effectively capitulated to the bank lobbies, and decided to hide behind the facade of market-based solutions to what is essentially a government-created problem.
In comparison to this wishy-washy approach, the solution promoted by the EU is the very model of clarity, on the lines of “none of us understands these large monsters, so we will rather deal with a large number of small monsters than continue having the opposite problem”. So there you have it – the Europeans have finally done something smart enough to make the American stewardship of the global financial system appear not only irresponsible but also untenable.
It is time to go Dutch.